The Feds Have No Faith in Recovery

The stock market has enjoyed a significant rally since the end of the first
quarter. The Bureau of Economic Analysis reported last week that the economy
grew at a 3.5% annual rate in the third quarter--a figure they achieved by
that claiming inflation was running at only a 0.8% annual rate, despite a sharp
drop in the dollar, a spike in commodity prices and record highs for gold.

The cyclical bull market in stocks and positive print on GDP has caused some
on Wall Street and in Washington to claim the recession has ended. Despite
all the good economic news, an end to fiscal and monetary stimulus is nowhere
in sight, precisely because policymakers know the happy news is artificially
derived.

A closer look indicates that neither the administration nor the Federal
Reserve believes its own recovery rhetoric. They understand that the
economy will not prosper without continued life support.

I believe removing such artificial stimulus is needed so the country can immediately
begin de-leveraging and to prevent the accumulation of yet more baneful debt.
What is truly amazing is how many people on Wall Street are foolish enough
to postulate that our problems have been solved. The stock market will not
be so easily fooled for much longer.

The Great Depression Part II was narrowly averted last year by slashing interest
rates to near zero. The Fed made money virtually free because the record
level of indebtedness ($34 trillion) in the economy required such low rates
so that borrowers could service their obligations. Otherwise a cataclysmic
domino effect of defaults and bankruptcies would have occurred. To avoid
that scenario, the public sector assumed some of the private sector's debt
and then subsequently took on a significant amount more. The debt of the
nation continues to increase at a 4.9% annual rate. All public debt is ultimately
the responsibility of the private sector to pay off--either directly or through
future taxes. As a result, the economy has never been more precarious than
it is today.

In spite of this, the stock market appears to be doing quite well. We've seen
a 57% rally off the March lows in the S&P
500. However, if you measure the market against other assets its performance
is much less impressive. Since the beginning of 2000 the S&P is down about
50% measured in terms of a basket of currencies other than the falling U.S.
dollar. The index is down nearly 80% against the real inflation hedge--gold!

The sad truth is that this recent market rally has been produced on the back
of a weakening dollar and the slashing of corporate overhead. Cutting payrolls
and research and product development projects are not a prescription for sustainable
growth. As I like to say, you can't burn your furniture to keep your house
warm forever. Eventually, top-line revenue growth must emerge or Wall Street's
game of beat-the-expectations will be short lived.

It's also worth noting that a country cannot devalue itself to prosperity
and that a bull market cannot survive an inflationary environment for long.
In the short run, nominal gains in the averages can occur since everything
priced in dollars tends to increase in value. However, the rally will be truncated
unless the Fed provides consumers and corporations with a stable currency.

The ramifications of a crumbling currency are vastly misunderstood. A strong
dollar is the cornerstone of a healthy economy. It is essential for balanced
growth and healthy investment to occur. On the other hand a weak currency decimates
the middle class and the corporate sector's ability to maintain earnings growth.
Inflation lies behind all infirm currencies, and it is inflation that destroys
the purchasing power of consumers. The diminished value of their wallets leaves
them with the ability to buy only non-discretionary items. As a direct result,
unemployment rates soar and economic output plunges.

I believe we will suffer from a protracted period of stagflation. Money supply,
as measured by M2, has increased 5% Y.O.Y. Meanwhile the output of goods and
services is falling. As long as the money supply is chasing a shrinking GDP
pie, there will be upward pressure on prices.

Making the situation even worse is the manner in which the money supply is
growing. The quality of growth is very low because the increase in supply is
coming from commercial bank purchases of Treasury debt, rather from an issuance
of credit to the private sector for capital goods creation. Total Loans and
Leases at Commercial banks are down 8.2% from last year. Meanwhile, the amount
of Treasuries held at all commercial banks is up 20% year-on-year.

That means money supply growth is emanating from government's misallocation
and redirection of capital. It isn't being loaned out to build mines and factories;
it is instead being loaned out to increase consumption and build even more
consumer debt.

If the Treasury and Federal Reserve truly believed the economy and the stock
market were on a sustainable recovery path, talk of extending and increasing
the home buyer's tax credit would be off the table. The Fed would already be
reducing the size of the monetary base. The truth, however, is that no one
in government really believes in this recovery. If they did, they would be
hiking interest rates and the deficit would be shrinking.

The government's realization of our precarious economic condition means its
largess will continue. Near term, that may ease some pain. So did the artificial
stimulus that gave rise to the housing boom. In the end, a protracted period
of a near-zero interest rates, along with endless economic stimulus, will spawn
another bubble and not a genuine recovery.

With more than 16 years of industry experience, Michael Pento acts as chief
economist for Delta Global Advisors and is a contributing writer for GreenFaucet.com.
He is a well-established specialist in the Austrian School of economic theory
and a regular guest on CNBC and other national media outlets. Mr. Pento has
worked on the floor of the N.Y.S.E. as well as serving as vice president of
investments for GunnAllen Financial immediately prior to joining Delta Global.